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Why it’s time to get back to basics

A guide to investing in small-cap companies.

The first half of 2017 proved to be an engaging time for the small-cap end of the UK market.

After a tough period, we’ve seen small caps reassert leadership over the wider UK market. We’ve seen a reduction in recessionary fears and concerns over sterling weakness that had initially benefitted large-cap multinational companies.

The investment backdrop in the UK has, in our view, remained supportive. Economic and corporate news flow has been generally reassuring. UK gross domestic product appears reasonably healthy, albeit exhibiting signs of slower growth. Unemployment and interest rates remain low, while the recent bout of sterling strength has shone a favourable light on small-caps due to their domestic bias.

As investor confidence has increased, there’s been a willingness to take on extra risk within the small-cap space. Investors are searching for extra returns within a generally lower-growth, lower-return environment. This has led to a period of strong demand for growth stocks, particularly those companies exhibiting superior growth characteristics (i.e. structural-growth companies, industry disruptors, technology innovators, and companies with the potential to gain significant market share).

Company fundamentals, valuations and balance sheet strength are always at the forefront of our minds. We look for investments that we think should do well regardless of the economic cycle, and where the entry valuation isn’t already capturing the majority of the upside potential.

A buoyant period

We’ve been able to find some interesting new ideas within the initial public offering market. The increase in the number of companies looking to list on the stock market is a marked change from the wait-and-see stance many companies adopted in the immediate aftermath of the Brexit vote last year. This pent-up demand has provided a window of opportunity to selectively invest in new stocks.

Merger and acquisition activity has also been buoyant. Businesses have been looking to acquire for growth or to divest in order to improve company focus and quality, such as balance sheet strength and profitability. Companies looking to raise new equity for acquisitions can also be a source of new investment opportunities.

The large size of the investible opportunities available mean we have several prospects to choose from. Our investment “sweet spot” now — the area of the market we’re able to find the most attractive opportunities — is around the £100 million (R1.7 billion) to £500 million (R8.5 billion) market-cap area. We believe this range offers a strong combination of attractively valued companies.

We think the FTSE Small-Cap Index represents a good proxy for this area of the market, as it includes stocks that are less than £500 million in size.1 The index is currently trading at around a 10% price-to-earnings discount to the FTSE All Share Index.2 This could be due in part to reduced liquidity at the smaller end of the market, but also could be due to the domestic skew that small-cap stocks have towards earnings. It has a much larger weighting towards the consumer sector, an area which has heavily de-rated and become less attractive to investors.

The market valuations chart below highlights the small-cap value proposition we see. It also illustrates how the larger FTSE AIM stocks have already hit quite full valuations — some are even off the chart.

While we’ve seen some of the growth-orientated names outperform and re-rate to higher valuations, some investors have shunned the domestic consumer-focused sectors. This has resulted in a wide valuation gap opening up between growth names and domestic cyclical companies. In our view, the uncertainty around Brexit negotiations and the mixed UK domestic economic data has clearly been weighing on sentiment towards these domestic-oriented stocks. We feel it’s not quite the right time yet to move wholeheartedly into domestic stocks. To us, it’s a matter of balancing this valuation opportunity against the earnings risk, which we are monitoring closely.

Under the microscope

Our research process involves keeping in close contact with many corporate management teams. The general impression we have been getting is that companies operating in niche or structural growth sectors continue to do well.

Conversely, businesses operating within the consumer discretionary space are starting to find the environment a little tougher. As inflation in the economy increases at a faster pace than real wage growth, the UK consumer is being squeezed. The result is lower discretionary spending power. As a result, we are less sanguine about the consumer-driven sectors such as retail, travel and leisure and consumer goods.

Looking ahead, we think bottom-up news flow and earnings growth are likely to play an increasingly important component of stock performance. There is a chance that rising bond yields and the prospect of rising interest rates may cap further price-to-earnings expansion.

A fast-paced and changing world presents investors with opportunities and threats, but our investing philosophy remains focused on the long term. We look for opportunities across a range of diverse stocks and sectors that exhibit both growth and value characteristics.

Despite an environment where attentions can easily be drawn to the next big thing, we focus on the pillars of our investment foundation (company fundamentals, valuation and balance sheet strength) to tackle the unknowns that may come our way.

Richard Bullas is the vice president, portfolio manager and research analyst, at Franklin UK Equity team.

  1. The FTSE Small-Cap Index is a small market capitalisation index consisting of the 351stand 619th largest listed companies of the London Stock Exchange. Indexes are unmanaged, and one cannot directly invest in them. They do not include any fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future performance. The price-to-earnings ratio is a valuation multiple defined as market price per share divided by annual earnings per share.
  2. The FTSE All Share Index is a capitalisation-weighted index comprising of the FTSE 350 and the FTSE Small-Cap Indexes. Indexes are unmanaged and one cannot directly invest in them. They do not include any fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future performance.

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